Framework shows how the most successful factors are bound to collapse under their own effectiveness
While academic research provides strong evidence that factors do well in the long run, it’s proving to be cold comfort to value investors who see a different story playing out in their portfolios. But as hard as it is to keep the faith right now, investors following that strategy might want to hold on.
“Factors like value and momentum are supported by extensive academic research showing that they have produced a positive premium over an 80+ year period,” said Validea Capital co-founder and President Jack Forehand in a new blog post. “But in many cases, the results haven’t been as good in practice as they have been in theory.”
The disjoint between expectation and reality is starkest among value investors, Forehand said, as the value premium has been negative for more than a decade. But he added that the same thing has happened with other factors, albeit to a lesser extent.
One explanation, he said, could be found in a factor life-cycle framework offered up by Resolve Asset Management’s Adam Butler.
In the first stage, a particular factor is discovered through research, which usually comes from the realm of academe. “Academics typically test factors on a long/short basis and want to see that stocks with the highest exposure to the factor produce a positive excess return, and that the stocks with the lowest exposure have negative excess returns,” Forehand said.
Focusing on value as an example, he noted that the factor’s discovery is largely attributed to academic work conducted by Eugene Fama and Ken French, which led to a seminal 1992 paper.
That led to the second stage in value’s life cycle, where it saw increased adoption among investment professionals. Intrepid managers blazed the trail, and over time its use expanded as more investors and fund managers deployed money into the strategy.
“This is where potential problems can come into the picture,” Forehand said. While companies that fall into the value bucket are characterized by certain short-term problems and risks, the fact that they’re largely overlooked allows investors willing to hold them to generate a premium over time. But as more money flows into such stocks, that premium can be reduced to the point of being negative.
That may sound discouraging, but Forehand maintained that it’s no reason for investors to throw their hands up and liquidate their factor-based holdings.
“Although this framework can help explain how largescale adoption can reduce or eliminate the premium associated with a factor, the fact that investors will withdraw capital when that happens also explains how it can come back to life,” he said. “If over time more investors avoid the factor than follow it, a long-term premium will still exist.”
